Nothing strikes fear in the heart of a small business owner like correspondence from the IRS. Of course, it's possible that you have overpaid and they're sending you money back. But the truth is, that's not likely. Typically, they're looking for some information on your business practices or examining your records, otherwise known as an audit. Audits are going to be a nuisance at best, keeping you from growing and running your business efficiently. Here's how to avoid a small business audit.
What Is an Audit?
[caption id="attachment_1111" align="alignright" width="500"]
Image via Flickr by CreditDebitPro[/caption] Knowing what is an audit is the first part of understanding what it is. The IRS has four different types of audits that they conduct:- Correspondence audit. This audit is probably the lesser of evils and, thankfully, the most common. It involves the IRS asking a few questions and sending you a letter. Sometimes all you have to do is send back proof of what you claimed, and that's it.
- Office audit. This takes the form of the IRS requesting you to visit their nearest office for an in-person audit, where they'll ask questions and review your supporting documentation.
- Field audit. When conducting this, the IRS visits your home or business to question you and your staff in person and review your records, including verifying if your home office is indeed a home office.
- Taxpayer Compliance Measurement Program (TCMP) audit. This is probably the most complex and time-consuming, as it entails the IRS going line by line through your tax return and verifying every step. TCMP audits are often randomly chosen from all returns received, so there isn't much you can do to avoid these audits.
Who Gets Audited?
TCMP audits aside, audits typically happen when the IRS has reason to believe there are inaccuracies in your tax return. With that being said, it isn't as if someone is closely reviewing your tax return. Instead, the IRS uses proprietary software to assign a score to each tax return based on what is claimed in the return. If the score is above a certain threshold, a revenue agent may examine your return more closely. Another factor increasing the likelihood of an audit is inconsistencies between your records and what the IRS has received, such as another company paying you money that you never reported.Audit Red Flags
Certain things are likely to increase your chances of being audited. Here are a few audit red flags:Claiming Your Personal Vehicle for Business
Many who own their own business use their vehicle for business reasons. That isn't uncommon, and you should deduct your legitimate business expenses. However, claiming to have only one vehicle and that it's mostly used for business will probably draw attention. While it is possible that you use a vehicle for just business and little else, it will incur suspicion from the IRS. Just be honest and keep all the requisite documentation to prove that claim.Claiming a Low Salary from Your S Corporation
If you own an S corporation and work for the company, you must pay yourself a reasonable salary. After that, the remainder of the profits can be claimed as owner's distribution and therefore not subject to FICA taxes. Check your salary on various salary websites to make sure it's within reason. Also, if your company is growing, it might be time to give yourself a raise.Significant Variations in Income or Expenses
It is common for a business to suffer a downturn in fortune or experience a growth surge. But either development may attract an audit if that change is significant. This possibility is especially strong when you report a dramatic increase in expenses without a commensurate rise in revenue.Mixing Business and Personal Expenses
Business expenses are deductible from your business revenue. Personal expenses are not. But there are some gray areas that could confuse taxpayers:- Home office deduction. If there is an area in your home used for business purposes only and serves as your primary place of business, you can deduct it. That said, you cannot deduct a guest room or office or a secondary office.
- Meals. Regular work meals are not business expenses. But you can usually claim half the cost if it's a business lunch with someone who doesn't work for your company or if you're on the road for business reasons.
- Entertaining clients. This expense used to be a deductible business expense. However, as of 2017, you can no longer claim the cost of entertaining clients.